Download Is an Optimal

Is an Optimal
Carbon Tax
Relevant?
Political forces threaten to push carbon taxes too high.
By Daniel Sutter
B
ob Litterman discusses the factors determining an
optimal price or tax for carbon emissions (p. 38). The
exercise illustrates that from an economic perspective
climate change is not catastrophic, but is likely to be of minimal importance in the ultimate determination of such a tax.
However, a carbon tax, once adopted, could easily be raised
to a level that chokes off economic growth—which would be
catastrophic. Attempting to calculate the optimal tax might
have an unintended consequence of making a terrible policy
accident more likely.
A carbon tax rate would not be set at a permanent level when
first implemented. As Litterman notes, the optimal tax would
likely increase over time and new information about climate
change or its consequences could update the optimal rate.
Adoption of a tax would have to include a mechanism for future
adjustments. Yet the optimal tax cannot be precisely calculated;
uncertainties about both the magnitude of losses and the probability distribution of losses preclude precision in this calculation.
Congress could not commit, even if it wanted to, to setting the
tax based on the solution to the economic optimization problem.
This should not come as a surprise because efficiency is logically
coherent but difficult to operationalize.
Excessive tax | Adoption of a carbon tax commits us to the
chosen mechanism for adjusting tax rates. The case for a tax
in the range implied by many economic models ($5 to $25 per
ton) is strong because, even if one is highly skeptical about
climate change and its potential adverse effects on society,
the probability of substantial costs must be closer to 0.2 than
zero. On the other hand, a carbon tax could be an economic
catastrophe if the tax ends up well above the range implied by
economic models.
An excessive tax is likely for three reasons. First, even within
the economic models, assumptions can be made that increase
the present value of the cost of carbon substantially. If truly
catastrophic effects are possible or if the catastrophic losses are
sufficiently likely, an optimal tax will be much larger. Climate
change poses uncertainty and not risk, as Litterman notes, and
Da niel Sut ter is the Charles G. Koch Professor of Economics at the
Manuel H. Johnson Center for Political Economy at Troy University and
a visiting scholar with the Center for Regulatory Studies at the George
Washington University.
we have no evidence to rule out a fat-tailed distribution of truly
catastrophic outcomes. Consequently, the adjustment process
could readily be freed from any tight anchoring.
Second, many people reject setting a carbon tax based on
economic efficiency. Some scientists and engineers believe that
carbon emissions must be reduced to zero over the next 50 years
to avert a catastrophe. Other proponents see the threat of climate
change as a means to achieve fundamental societal changes. A
carbon tax of even $100 a ton translates to about $1 per gallon of
gas, insufficient to stop Americans from driving their cars. Many
constituents would demand a tax well in excess of any calculated
economic optimal, and would lobby for steep increases. Thus
even if the establishment of a carbon tax is cast in the framework
of efficiency, once a tax and adjustment mechanism are in place,
the tax could be increased on other grounds.
Third, political equilibrium suggests a balancing of these
lobbying interests. Those advocating a carbon tax based on
efficiency would oppose any increase above the efficient level,
but the strength of their opposition would depend on their loss
relative to the efficient price, which is small for a price just above
the efficient level. Efficiency advocates would only really raise a
fuss as the price rises beyond the range of possible efficient values.
Meanwhile, advocates of phasing out fossil fuel use would engage
in a full-court press to raise the tax from the efficient level. Political balancing of these two lobbying groups would lead inevitably
to a price higher than the efficient level, even if each group has
similar overall political influence. As a result, the economically
efficient price is implausible as a political equilibrium.
While a small carbon tax might have net benefits, politically
our choices are likely between an excessive and perhaps prohibitive tax and no tax at all. Once an apparatus for carbon taxation
is in place, discretion would lead to an excessive price. Citizens’
only recourse, if government discretion cannot be checked, is not
allowing government action at all. The zeal of climate change proponents ironically might make adoption of an efficient tax less
likely. The argument here is of a second-best nature: it is not that a
carbon tax of any magnitude is harmful, but that the equilibrium
tax will be worse than no tax.
Projected economic growth provides perspective on the case
for a carbon tax. As Indur Goklany has argued, future generations
in 2100 or 2200 will be significantly better off than people today
without mitigation under all climate change scenarios. This suggests that the gains from an optimal carbon tax would be small.
But future growth is not guaranteed, especially if aggressive policies
against climate change are adopted. A carbon tax to reduce emissions to zero would likely devolve into carbon rationing. Modest
taxes will not reduce the use of fossil fuels to zero, while a tax large
enough to do so would result in evasion. Consequently, commandand-control policies would be required to ration fossil fuel usage
toward zero. Given that energy use drives the economy, carbon
rationing would effectively amount to energy central planning.
Calculating an optimal tax might have the unintended consequence of making such a catastrophe more likely. Who could
be against an optimal carbon tax if it raises the price of gasoline
Summer 2013
| Regulation | 47
Energy
&
E nv iro n me mt
by a quarter a gallon or less? Economists offer a disarming case
for taxing carbon. But promises regarding taxes are notoriously
unreliable; the 16th Amendment was adopted in part because
Americans were promised that only the rich would ever pay an
income tax. Once established, politicians will set tax rates based
on predictable political forces.
Economic growth has been the exceptional condition in
human history, not the normal, and growth only began with the
establishment of the institutions of the market economy. Energy
central planning would force abandonment of market allocation of factors of production. Given the potential for capture
by interests looking to eliminate carbon emissions, a carbon tax
could spell the end of growth, courtesy of government planning.
Although catastrophe scenarios are usually invoked to motivate
action on climate change, the true catastrophe would be to allow
an excessive carbon tax to undermine prosperity.
Readings
■■ “A Theory of Competition
among Pressure Groups for Political
Influence,” by Gary Becker. Quarterly
Journal of Economics, Vol. 98 (1983).
■■ “Discounting the Future,” by
Indur Goklany. Regulation, Vol. 32,
No. 1 (Spring 2009).
■■ “Discretionary Policy Implementation and Reform,” by Daniel
Sutter. Journal of Economic Behavior
and Organization, Vol. 39 (1999).
■■
“Rethinking Wedges,” by Steven
J. Davis, Long Cao, Ken Caldeira,
and Martin I. Hoffert. Environmental
Research Letters, Vol. 8 (2013).
■■ “The Constitution of Economic
Policy,” by James M. Buchanan.
American Economic Review, Vol. 77
(1987).
■■ The Reason of Rules, by Geoffrey
Brennan and James M. Buchanan.
Cambridge University Press, 1985.
■■ “Towards a More General Theory
of Regulation,” by Sam Peltzman.
Journal of Law and Economics, Vol. 19
(August 1976).
Politics and
Climate Change
What impedes a carbon tax?
By Shi-Ling Hsu
B
ob Litterman makes an important contribution to the
discussion of the economics of climate change (p. 38).
He cuts through much of the debate over climate policy
and manages to leave the lay reader with a basic understanding of Capital Asset Pricing Model (CAPM) theory and how
it could apply to climate policy. In my view, this essay should
be required reading for climate policy wonks. The debate over
climate change and climate policy is ossified, with very little
insightful material being added. Litterman’s essay is truly different and useful.
I say this despite my disagreement with a number of his assertions about the state of the literature on climate science and
Shi-Ling Hsu is an economist and professor of law at Florida State University College of Law.
48
| Regulation | Summer 2013
climate policy; they seem to me to be based on a literature that is
slightly outdated. But that only reinforces his tentative conclusion that carbon should be priced, and should be priced higher
than the level that most economists believe to be optimal.
Two camps |
Litterman’s thesis is that the risks of climate
change are usefully analyzed as a hedge fund manager might. In
the interests of making climate policy more palatable to those
who doubt the science behind climate change, a climate policy
like a carbon tax is sometimes described as a measure of “insurance” against the risk of climate change. But this is wrong;
the risks of climate change are non-diversifiable. The damages
from climate change are such that many interdependent claims
could be filed in a short period of time. Private insurers did not
and mostly could not diversify against the risks of a $50 billion
event like Hurricane Sandy, let alone the increased number
of strong hurricanes that climate change is expected to bring
about. If climate change were to bring about both stronger hurricanes and drought at the same time, then private insurance
would be even less available. Litterman’s insight is that climate
change thus becomes a pure question of risk aversion.
If you cannot diversify away risks, the question becomes, “how
willing are you to assume risk? How much would you demand
to assume risk?” It should surprise no one that respondents to
this question fall roughly into two camps: the risk-averse climate
policy advocates and the risk-taking climate skeptics. The two
share little in common.
But Litterman’s essay delves into this further. Why, fundamentally, are some people risk-averse and some risk-taking
when it comes to climate change? Part of the answer, clearly,
depends on one’s view of the science of climate change. Skeptics of climate policy tend to doubt the robustness of climate
science. But a more nuanced view is that climate skeptics are
more risk-taking because they do not believe that the risk of
climate change is high enough to justify the dampening of
economic growth.
Some members of the risk-taking camp may also view climate change as a hedge, not a risk, because the harms from
climate change would themselves reduce economic growth,
thereby reducing emissions. In other words, climate change,
because of the strong correlation between economic growth
and greenhouse gas emissions, provides its own negative feedback mechanism. Litterman gives this view more credence
than it deserves because the economic damages caused by climate change lag emissions by very long time frames. A lagged
negative feedback mechanism would lead to a dynamic path of
temporary but suboptimally high emissions, leading to later
suboptimally high damages. The hedge view of climate change
is flawed in this respect. Be that as it may, Litterman’s description is accurate. Some combination of these two beliefs leads
this camp to believe that whatever economists say, the price of
carbon should be lower. As Litterman points out, this view is
predicated on the belief that the damages of climate change,
while non-diversifiable, are not catastrophic.